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Hedge Funds Rush Into Debt Trading With $108 Billion

Michael Platt, co-founder of BlueCrest Capital Management LLP. BlueCrest, the London-based firm led by former JPMorgan trader Platt, has hired more than 30 people for its New York-based team since 2010, while boosting its holdings by about $12 billion since then, to $36 billion. Source: BlueCrest Capital Management LLP via Bloomberg

May 8 (Bloomberg) -- Hedge funds using debt-trading
strategies honed on Wall Street are expanding at a record pace
as they profit from risks big banks are no longer taking.

BlueCrest Capital Management LLP doubled its New York staff
in the two years through December, while Pine River Capital
Management LP increased its global workforce by one-third in
2012. Hedge-fund firms are hiring from companies such as
Deutsche Bank AG, Barclays Plc and Bank of America Corp. as
their credit funds have attracted $108 billion since 2009, data
compiled by Chicago-based Hedge Fund Research Inc. show.

The flow of funds and people is taking place as regulators
demand banks curb proprietary trading and back riskier wagers
with more capital to prevent another financial crisis. That has
allowed so-called shadow-banking firms to expand in businesses
contracting at the largest lenders, including distressed-debt
trading and fixed-income arbitrage, a strategy that seeks to
profit from short-term price differentials.

“The regulatory posture in the U.S. and in Europe is
unequivocal: They want to transfer risk to the shadow-banking
system,” said Roy Smith, a finance professor at New York
University’s Stern School of Business and former Goldman Sachs
Group Inc. partner. “It does come at the cost of interfering
with some financial capabilities of the large banks to function
as market makers and arbitrage providers.”

BlueCrest, Millennium

Credit hedge funds, part of a less-regulated shadow-banking
system that also includes money-market funds and real estate
investment trusts, are still minnows compared with Wall Street’s
largest lenders. BlueCrest, Pine River Capital and Millennium
Management LLC, three of the fastest-growing funds, have
combined assets of about $67.6 billion, according to people with
knowledge of the matter. JPMorgan Chase & Co.’s corporate and
investment bank had an average of $413.4 billion in trading
assets in the first quarter, up 5.6 percent from a year earlier.

Still, debt-focused hedge funds are expanding rapidly. They
attracted $41.4 billion from pension plans, wealthy individuals
and other investors in 2012, the most since 2007, after a
combined $57.4 billion of net inflows in the two previous years,
HFR data show. The three-year total was a record.

Hedge funds focusing on fixed-income arbitrage boosted
returns by 51 percent last year, while fixed-income, currencies
and commodities-trading revenue at the nine largest banks rose
14 percent, excluding accounting charges, according to data
compiled by Bloomberg.

‘Brain Drain’

The strategy, once employed by Long-Term Capital Management
LP, focuses on exploiting pricing inconsistencies between assets
rather than making bets on the market’s direction at a time when
Berkshire Hathaway Inc. Chairman and CEO Warren Buffett and
Goldman Sachs President Gary Cohn are predicting losses for
fixed-income investors when interest rates rise.

Debt funds have received more inflows and swelled more than
any other category since 2009 to include $639.7 billion of
assets as of March 31, HFR data show. They have surpassed the
size of equity-hedging strategies, which reported about $4
billion of redemptions in the period and now include $638.7
billion of assets, according to the data.

That growth also is attracting talent.

“There’s a continuous brain drain on Wall Street,” said
Jason Rosiak, head of portfolio management at Newport Beach,
California-based Pacific Asset Management, the Pacific Life
Insurance Co. affiliate that oversees about $3.75 billion.
“Hedge funds are playing in asset classes where they previously
hadn’t played.”

Distressed Debt

Scott Martin and C.J. Lanktree, who ran a distressed-debt
group at Deutsche Bank until last year, joined New York-based
Solus Alternative Asset Management LP, where they’ve raised $1.1
billion for two funds that invest in bankruptcy claims.

Such claims are considered risky because they’re backed by
companies that have already defaulted on their debt, are
infrequently traded and are dependent on the outcome of legal
disputes. Banks that decide to hold such investments would be
required to have more equity to absorb potential losses compared
with higher-rated securities, such as government debt.

“There are businesses based on our capital regulation
we’ll not be able to do” that “hedge funds will be able to,”
Deutsche Bank Chief Financial Officer Stefan Krause, 50, said at
an April 25 conference in Berlin. “If I had to bet who is going
to benefit the most post-crisis from the asset appreciation you
have coming, then certainly hedge funds.”

BlueMountain Capital

James Staley, the JPMorgan executive who took over the
firm’s investment bank in 2010 and was once seen as a candidate
to become chief executive officer, quit in January to join $13.6
billion hedge-fund firm BlueMountain Capital Management LLC.
BlueMountain was co-founded by Andrew Feldstein, who helped
create the credit-derivatives market when he worked for JPMorgan
in the 1990s.

BlueMountain reaped as much as $300 million from JPMorgan’s
$6.2 billion trading loss last year by betting against the bank
and then helping JPMorgan unwind its positions, people with
knowledge of the matter said at the time.

BlueCrest, the London-based firm led by former JPMorgan
trader Michael Platt, has hired more than 30 people for its New
York-based team since 2010, while boosting its holdings by about
$12 billion since then, to $36 billion, according to a person
with knowledge of the matter who asked not to be named because
the expansion hasn’t been publicly discussed.

Millennium Expansion

The firm added at least three people from Deutsche Bank
this year as it seeks to create what its website calls an
“investment-bank quality” trading group. Hires included
interest-rate derivatives trader William Yearick, mortgage-debt
trader John Roach and distressed-credit analyst Matt Siravo,
people with knowledge of the matter said at the time.

Last year, BlueCrest hired Eugene Gokhvat from Morgan
Stanley and John McNiff, who was co-head of trading in
commercial-mortgage securities at Bank of America.

Renee Calabro, a spokeswoman for Deutsche Bank, declined to
comment, as did Kerrie McHugh at Bank of America.

Pine River, which hired Steve Kuhn in 2008 from Goldman
Sachs to head fixed-income trading, has almost tripled its
assets under management in the past 15 months, to $13.5 billion
as of April 1 from $5.4 billion in January 2012.

Millennium expanded its staff by 32 percent to 1,250 people
in 2012, adding Barclays trader Brian Maggio and Nomura Holdings
Inc.’s Markus Weber, while increasing its assets by 25 percent,
to $16.9 billion as of Dec. 31, regulatory filings show. Some of
its hires this year include interest-rates derivatives trader
Markus Meister from Deutsche Bank and UBS AG’s Preben Ramm.

Falling Salaries

The New York-based firm, run by Israel “Izzy” Englander,
accelerated its expansion into fixed income in October 2008,
when it hired Michael Gelband, a former global head of capital
markets at Lehman Brothers Holdings Inc., less than a month
after that company collapsed. Millennium Partners LP, the
multistrategy fund that the firm uses to invest all of its $18
billion in net assets, formed a Cayman Islands subsidiary in
June 2010 called Millennium Fixed Income Ltd.

Tripp Kyle, a spokesman for Millennium, declined to comment
about the expansion, as did Patrick Clifford, who represents
Pine River in New York, and Ed Orlebar for BlueCrest.

Bankers and traders are departing as average investment-banking salaries fell 14 percent last year compared with a 3
percent decline in salaries at alternative-asset managers,
according to eFinancialCareers.com. They’re seeking to deploy
skills learned at the biggest banks to capture business that
those same firms now can’t afford to maintain.

“Business strategies are moving out of the banks and into
the hedge funds,” said Constance Melrose, managing director of
eFinancialCareers.com in the Americas. “You do need some of the
people to deliver those strategies, and you have the
opportunities to get those people.”

Bankruptcy Claims

One of those opportunities is in bankruptcy claims and
other forms of distressed debt. O’Malley Hayes, who sourced and
traded illiquid loans at Bank of America, departed in 2010 to
become a principal at Bayside Capital, an affiliate of H.I.G.
Capital, a $12 billion private investment firm.

Fixed-income arbitrage business also is flowing to hedge-fund managers from banks poised to lose $17 billion of revenue
in fixed income, currencies and commodities by 2016 because of
levies and regulation, according to an April 22 report by
Deutsche Bank analysts.

“We’ve seen some banks publicly pull back from activities
that would require them to commit their balance sheet in a big
way to fixed income,” said Shubh Saumya, a New York-based
partner at Boston Consulting Group. “A hedge-fund balance sheet
is a different type of balance sheet.”

Regulatory Assets

UBS, Switzerland’s largest bank, said in October that it
plans to cut 10,000 jobs and exit some of the most capital-intensive trading businesses, chopping about 80 billion Swiss
francs ($85 billion) from the 110 billion francs of risk-weighted assets in its fixed-income business.

Firms including Millennium and BlueCrest reported an
increase last year in what are known as regulatory assets under
management, signaling an increase in fixed-income arbitrage
strategies that usually use borrowed money and repurchase
agreements to boost returns.

Because fixed-income arbitrage involves buying some bonds
and betting against others through short sales, practitioners
enter into reverse repurchase agreements to obtain securities
they need to sell short. One example: If Japanese sovereign debt
has higher yields relative to Treasuries than historically has
been the case, a fixed-income arbitrage trader might buy the
Japanese bonds and sell short U.S. government debt to profit
when the spreads between the two reverted to customary levels.

Reverse Repos

Under a methodology developed by the U.S. Securities and
Exchange Commission, these reverse repurchase agreements are
counted as assets, even though the related short positions help
offset risk. As a result, fixed-income arbitrage can cause
regulatory assets under management to balloon. The measure
differs from net assets under management, the industry standard.

At Millennium, the firm’s regulatory assets under
management soared 67 percent last year to $198.2 billion from
$119 billion, while its net assets under management increased
about 25 percent to $16.9 billion, according to filings.
BlueCrest’s regulatory assets jumped 50 percent to $95.4 billion
last year, while its net assets under management rose 15 percent
to $35.3 billion, filings show.

Volcker Rule

Fixed-income arbitrage strategies are benefiting from “a
relative lack of competition from large banks,” Aetos Capital
LLC, which invests in hedge funds, said in an April 8 SEC
filing. The New York-based firm said its Aetos Capital Multi-Strategy Arbitrage Fund LLC had a 9.2 percent return for the 12
months ended Jan. 31.

One reason for the retreat is the 2010 Dodd-Frank Act’s
Volcker rule, which seeks to curb so-called proprietary trading,
or betting with a lender’s own money.

As primary dealers, most large banks made markets in
government and corporate bonds and also carried inventories of
securities. The market-making function gave them insight into
trading patterns by institutional customers, allowing them to
spot and sometimes capitalize on anomalies in the pricing of
bonds. Banks also formed proprietary-trading desks that used
their own capital to make similar wagers. Because pricing
discrepancies were often small, the firms used leverage, or
borrowed money, to generate higher profits, expanding the size
of their balance sheets in the process.

Proprietary Trading

“These large players provided the grease to allow the
fixed-income markets to work,” said Brad Hintz, a former Morgan
Stanley executive who now works as a bank analyst at Sanford C.
Bernstein & Co. in New York. “The price of them doing that was
they were taking risk.”

While the Volcker rule hasn’t taken effect because
regulators are still working out details, some banks have
already closed proprietary trading desks. Hedge funds, because
they aren’t subject to the rule or to capital requirements, can
take on the risk, increasing potential returns.

The move of fixed-income trading strategies to hedge funds
could pose a risk to the financial system, according to Fed
Governor Daniel K. Tarullo. He warned in a May 3 speech that
regulators haven’t adequately addressed the dependence of some
banks and other financial companies on short-term, borrowed
money that can dry up quickly in a crisis, which contributed to
the 2008 collapses of Bear Stearns Cos. and Lehman Brothers.
Cracking down on such market funding only at banks could push
those businesses elsewhere, he said.

‘Regulatory Pressure’

Pine River’s $3.9 billion Fixed Income Fund posted a 35
percent return last year, the most among 15 hedge funds focused
on debt-arbitrage strategies, according to HSBC Holdings Plc
data. Millennium Partners has returned 3.41 percent this year
through April 18, HSBC data show. BlueCrest’s $1.6 billion
Multi-Strategy Credit fund gained 4.7 percent this year through
April 30, a person familiar with the returns said.

The Solus Recovery Fund, which has investments in claims
from the Lehman Brothers and MF Global Holdings Ltd.
bankruptcies, returned 17.8 percent in the 13 months ended March
29, according to an investor letter obtained by Bloomberg News.

“As a general matter, any time you have a big financial
crisis like Long-Term Capital in 1998 or the recession of 2008,
fixed-income arbitrage usually gets hurt during the crisis and
has very good returns afterwards,” said Anne Casscells, chief
investment officer of Aetos Capital’s absolute-return
strategies. “What is different between now and 1998, is that
now the banks are under regulatory pressure not to return to
proprietary trading or even positioning.”

Long-Term Capital

Long-Term Capital Management, one of the world’s biggest
hedge funds at the time, lost more than $4 billion, mostly as a
result of a highly leveraged fixed-income arbitrage strategy,
after a debt default by Russia. It required a bailout by banks
overseen by the Fed.

Profitability at the biggest banks has declined as
regulators globally sought to fortify the financial system after
the mortgage-debt crisis resulted in $2 trillion of writedowns
and credit losses after June 2007. The average return on equity
at Wall Street firms fell to a range of 10 percent to 13 percent
in 2012, from 15 percent to 20 percent before 2008, according to
a Boston Consulting Group study released April 30.

Hedge-fund firms also are benefiting from demand by
investors seeking relief from a fifth year of benchmark
borrowing costs held at about zero in the U.S., the world’s
biggest economy.

Fed Funds

The Fed has funneled more than $2.5 trillion into the
financial system since 2008 to help galvanize a global economy
that economists expect will grow 2.28 percent this year, slower
than the 2.32 percent annual average since 2005, Bloomberg data
show. Japan’s central bank pledged to double that nation’s
monetary base by the end of 2014 with more asset purchases.

Yields on company debt globally dropped to an unprecedented
low of 3.09 percent on May 2, according to Bank of America
Merrill Lynch index data. Credit hedge funds received $9.4
billion of deposits during the first three months of 2013, HFR
data show.

Risk Management

Alternative-asset managers say they are enforcing risk-management measures as they expand. Traders at BlueCrest face
having their capital allocations cut in half if they lose 3
percent of the money under their management, according to a
person with knowledge of the matter. If their portfolio drops a
further 3 percent, the trader will lose his allocation and
possibly his job, the person said.

Millennium has 145 teams of traders who run their own
strategies under risk guidelines set by the firm, according to a
person with knowledge of the company.

Rule makers have been crafting legislation with the idea of
enabling “risk to transfer itself into the so-called shadow-banking community, where it would be put into relatively small
repositories that will be relatively insignificant if they
fail,” said NYU’s Smith. If these hedge-fund firms fail, he
said, “the real question is, to what degree will the market
suffer from it.”